Foreclosure Nation

Mortgaging the American Dream

Shari B. Olefson, JD, LLM

Global Crisis

Europe’s Crisis of Liquidity

Posted on Wednesday, December 1, 2010

Instead of long-term insolvency, running out of cash is what causes financial crises like the one slowly unfolding in Europe. Yet much of the effort by policy makers around the globe has been to shore up solvency, not stabilize sources of financing. Unless that changes, the world will lurch from crisis to bailout and back again to crisis. Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year. The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required. Sadly, this is an all-too-familiar story. Financing was the Achilles’ heel of banks that went to the brink, or over it, in 2008. The likes of Lehman Brothers, Northern Rock of Britain, Washington Mutual, Royal Bank of Scotland and Fortis of Belgium may have had inadequate capital. But death by insolvency is usually a slow one. Death, or near death, through lack of liquidity is rapid. If Portugal’s banks also get sucked into the continuing European maelstrom, financing troubles again will be the cause. Banco Espirito Santo and Millennium BCP have high capital ratios and look solvent as a result. But like the two big Irish banks, they have loan-to-deposit ratios above 160 percent, making them dependent on unreliable sources of funds. Governments, meanwhile, differ from banks because they do not finance themselves through deposits. However, they do need to continue rolling over debt as well as pay for new deficits. As with banks, the more stable their sources of money, the better. A domestic private sector flush with cash and willing to buy government bonds helps. The lack of stable financing is why the Spanish government is vulnerable. Its debt-to-G.D.P. ratio is expected to end the year at 63 percent, below the euro zone average. But Spain has a current account deficit of 4.4 percent of G.D.P., meaning it needs to attract large inflows each year from abroad. The government’s habit of financing itself with relatively short-term debt — it needs to refinance 149 billion euros ($195 billion) next year — makes it even more susceptible to the markets. Financing instability does not just cause crises, it also forces bailouts. It is usually thought too risky to let a bank (or government) go under, because the creditors who get hurt will then withdraw their cash from other banks (or governments) with similar profiles. That was the experience when Lehman was allowed to fail. It was also the argument against forcing losses on the senior creditors of Ireland’s banks. In a febrile climate, even relatively small institutions are deemed too big to fail. It is about time policy makers did something about financing structures that invite liquidity problems. And they have: the new Basel III bank rules do, finally, address the issue as well as toughen up solvency standards. But no action is required until 2018 — and, yes, that year is not a typo. Some governments, notably Britain, France and Germany, are planning to impose higher taxes on banks that rely more heavily on short-term “hot” money to finance themselves. This is a good idea, as it gives banks an incentive to secure more stable financing. The snag is that this initiative has been diluted because it will not be global. A White House plan for such a levy in the United States seems to have been killed by Congress. In the meantime, there will be more crises and bailouts. And banks, governments and their creditors will draw the logical conclusion: it still pays to be foolish.